Insights
The Next Leg Higher for Emerging Market Debt
Since the US election results became clear, market participants have felt comfortable taking on more risk in their portfolios with cash being put to work ahead of year-end. This market move has been supercharged by announcements that a vaccine is close. These developments have been particularly beneficial to emerging markets (EM), where president-elect Joe Biden is seen as a globalist and thus likely to undo some of the disruptions brought on by the Trump administration. Global trade stands to benefit, also helped by the news that an Asian free trade agreement – the Regional Comprehensive Economic Partnership (RCEP) – has been signed.
So the world looks like a slightly happier place for EM with growth expected to pick up in 2021 but, so far, there are only isolated signs of inflation. The PriceStats® indicators, developed by State Street Global Markets, suggest that there are few pressures on the inflation front for EM nations outside of Brazil and Turkey. As such, we expect a period of more balanced monetary policy with some central banks, such as Turkey, raising rates while others remain in easing mode, such as Indonesia. The enigma in the EM world remains China, where an expanding economy in 2020 has resulted in the yield on 10-year bonds pushing 80bp higher from the lows seen in the immediate aftermath of the COVID-19 crisis. This comes despite signs that inflation remains contained and a strengthening of the yuan.
The better growth outlook may cause some investors to prefer hard currency funds, where returns are more about credit quality and where stronger growth should ensure countries have an improved ability to service their debt. Indeed, the ICE BofA 0-5 Year EM USD Government Bond ex-144a Index has returned 2% year to date in USD unhedged terms despite its low duration of under 2.5 years.1 Given a yield to worst of more than 2.3%, this is one way of providing a portfolio with an uplift to running yield while keeping duration risk low.
Upside and Downside of a Declining USD
That said, a key view of State Street Global Markets is that the USD is going to continue its depreciation. The combination of the USD enjoying little support from interest rate differentials, coupled with hopes of a return to a more normal environment, could erode the appeal of the USD as a safe haven. As the chart below illustrates, this would favour local currency bonds. There is an especially close inverse relationship between changes in the trade-weighted USD (DXY) and returns on the local currency index, but much less so for the hard currency index.
Source: Bloomberg Finance L.P., as of 13 November 2020.
To put into context the significance of the currency, as noted above, Chinese bond yields may have risen since the start of April but overall returns have still been positive (+4.5%) as the combined currency (+7.2%) and coupon (+2.0%) returns have offset the bond losses (-4.5%).2 Moreover, the basket of currencies represented by the Bloomberg Barclays EM Local Currency Liquid Govt Index continues to look 7.3% undervalued versus the USD from a historical perspective.3
The greater spike in returns for local currency versus the hard currency index since the US presidential election (also visible on the chart4) suggests investors now have a more favourable mindset towards taking on risk. The upsurge in demand may also be a product of the higher yield on offer, with the Bloomberg Barclays EM Local Currency Liquid Govt Index providing a yield to worst of over 3.7%.
With both the local and hard currency EM debt funds having the USD as the base currency, hedging out the risk of a USD depreciation makes sense. The annualised cost of hedging the EUR-USD with 1-month forwards was around 3% in December 2019 and is now around 0.8%, making the ability to switch between EUR-hedged and unhedged emerging market debt exposures less of a performance concern.
How to play this theme
State Street Global Advisors, in partnership with Bloomberg Barclays, has introduced a currency-hedging methodology new to the ETF market, hedging only the USD base currency return of the index to EUR. It is currently the only such ETF with this feature, allowing investors to harness the full potential of emerging market debt local currency in 2020.
If longer-term forecasts of a weaker dollar play out, this could support emerging market assets. Having the ability to hedge this risk could also greatly help EUR-based investors.
To learn more about the funds that can provide exposure to the themes described above, and to view full performance history for these funds, please follow the links below:
SPDR Bloomberg Barclays Emerging Markets Local Bond UCITS ETF (Dist)
SPDR Bloomberg Barclays Emerging Markets Local Bond USD Base CCY Hdg to EUR UCITS ETF (Acc)
SPDR ICE BofA 0-5 Year EM USD Government Bond EUR Hdg UCITS ETF (Acc)
European-Domicilied ETP Segment Flows (Top/Bottom 5, $mn)
European-Domiciled ETP Asset Category Flows ($mn)
Sources: Bloomberg Finance L.P., for the period 12-19 November 2020. Flows are as of date indicated and should not be relied upon as current thereafter.